CONSULTING GROUP INVESTMENT ADVISOR RESEARCH DECEMBER 3, 2013 Adverse Active Alpha SM Manager Ranking Model MATTHEW RIZZO Vice President Matthew.Rizzo@ms.com +1 302 888-4105 Introduction Investment professionals almost universally consider alpha to be the holy grail of money management in terms of performance measurement. After all, why endeavor to actively manage investments if the results are no better or worse than the indices? Why pay fees for active management when one can pay lower fees to passively index a portfolio? Of course, the answer is that active money managers hope to outperform. Our analysis indicates that over time perhaps on average about 50% to 60% of active domestic stock pickers outperform their respective indices before fees. But how do you find these managers in advance? In order to improve our odds of adding alpha to client portfolios, Consulting Group Investment Advisor Research (CG IAR) recently incorporated the proprietary in-house Adverse Active Alpha SM manager ranking model into our research process. The model attempts to identify active equity money managers with strong stock picking skills and the ability to outperform indices and peers. Our back tests show Adverse Active Alpha top-decile-ranked managers outperformed their respective benchmarks from year-end 2000 through 2012 by 460 basis points annualized in the large cap growth category and greater than 320 basis points in the large cap value category. Because of our conviction in the efficacy of the rankings and the model s unique properties, we filed a patent application for the proprietary in-house process that is now pending. Adverse refers to the ability to outperform in a variety of market environments and when conditions are difficult for active manager relative performance. Difficult periods are times when active management does not perform well relative to the index, as opposed to down market periods. At various times, active management has experienced difficult relative performance periods in up, down, and flat markets. We developed a set of factors to help discern which periods were more difficult for active managers that we utilize to identify managers able to overcome these headwinds and outperform in the face of adversity. Active refers to managers with high active share i.e., managers whose portfolios look different from the index and moderate to low tracking error. In this way, the ranking seeks to find managers that are active, but not taking outsized factor bets, such as large sector or industry bets and that have some degree of style consistency. The combination of high active share and low tracking error is fairly uncommon among active managers, but we believe these traits may point toward managers with strong stock picking skills. Alpha refers to the ability to add value relative to an index and/or peers. Back tests indicate that highly ranked managers as a group outperformed the index and style peer group over subsequent periods and relative to active share alone. By combining the adverse component with the active component, we believe we increase the odds of finding some of the most proficient stock pickers. This report is only to be used in connection with investment advisory programs and not brokerage accounts. This is not a "research report" as defined by FINRA Rule 2711 and was not prepared by the Research Departments of Morgan Stanley Smith Barney LLC or its affiliates. INVESTMENT PRODUCTS: NOT FDIC INSURED*NO BANK GUARANTEE*MAY LOSE VALUE 2013 Morgan Stanley Smith Barney LLC. Member SIPC. Consulting Group is a business of Morgan Stanley Smith Barney LLC.
ADVERSE ACTIVE ALPHA RESULTS Positive alpha is the desired end to our quest. So what is the alpha potential for our model? In a back test looking at the model rankings as of the end of year-end 2000, managers in the large cap growth category ranking in the top decile (top 10%) outperformed the Russell 1000 Index by 460 basis points annually over the following 13 calendar years. Top-decile-ranked large cap value managers outperformed the Russell 1000 Value Index by more than 320 basis points over the same time period. Additionally, relative performance declines significantly after the first quintile (top 20%), which we expect given that the model is intended to find only the top stock pickers and looks for managers with specific characteristics. Of course, some managers with rankings below the top quintile performed well. However, the results were more random and hard to predict. Also interesting to note is that within the large cap value space, the top quintile ranked managers included seven of the ten top performing managers over the subsequent 13-year time frame. 1 Table 1 ADVERSE ACTIVE ALPHA LARGE CAP GROWTH BACK TEST RESULTS FOR THE YEARS 2000 THROUGH 2012 Decile As can be seen in Table 3, top-decile-ranked managers on average also exhibited lower volatility than their benchmarks. Table 3 ADVERSE ACTIVE ALPHA LARGE CAP GROWTH AND VALUE VOLATILITY FOR THE YEARS 2000 THROUGH 2012 Annualized Performance Relative to Russell 1000 Annualized Performance Relative to Average Manager Top Decile 4.60 1.66 Deciles 2 through 10 2.73-0.21 Table 2 ADVERSE ACTIVE ALPHA LARGE CAP VALUE BACK TEST RESULTS FOR THE YEARS 2000 THROUGH 2012 Annualized Performance Annualized Performance Decile Relative to Russell 1000 Relative to Average Value Manager Top Decile 3.26 2.55 Deciles 2 through 10 0.70-0.17 Russell 1000 Annualized Standard Deviation 17.78 18.36 Annualized Standard Deviation Value Russell 1000 Value 14.74 16.08 Chart 1 HOW OFTEN IS ADVERSE ACTIVE ALPHA RIGHT? SUCCESS RATE FOR MANAGERS IN TOP TWO DECILES FOR THE PERIOD FROM DECEMBER 2000 THROUGH 2012 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Value Percentage that Outerformed Index Percentage that Outperformed Peer Group WHY USE THE ADVERSE AND ACTIVE COMPONENTS TOGETHER? Our contention is that by using either of the components above independently (Adverse or Active), one can derive a pool of managers with higher alpha generating potential. However, by combining the two components together, one increases the odds of finding a pool of stock pickers with the ability and demonstrated skill to outperform benchmarks and peers going forward. Not only does the model look for managers that are truly different from the index, but it then goes further and identifies managers that have performed well even in times when active managers have struggled and mitigates market effects to find highly skilled stock pickers, as opposed to those that simply ride the tide when the majority of active managers are outperforming. We believe that the back tested performance results are compelling and the process sufficiently unique to justify filing the Adverse Active Alpha ranking model for patent protection. Of course, not all of the highly ranked individual managers will outperform. However, we believe the odds of achieving success are greater and the alpha potential is meaningfully higher. HOW DID THE RESULTS COMPARE TO ACTIVE SHARE ALONE? While the performance results look compelling for managers that score well using the Adverse Active Alpha methodology, one key question is how the results compare to using active share alone. Results of certain studies have shown that investment managers with higher active share performed better than those with lower active share over time. 2 Since active share is one component of the Adverse Active Alpha model, some might wonder how its results compare to simply using active share alone. 2
Using the same time period noted above for our back test yearend 2000 through year-end 2012 we can compare the Adverse Active Alpha results to those of active share alone. In order to do this, we simply ranked the managers by their year-end 2000 active share scores and then looked at the subsequent performance results by decile. Chart 2 ADVERSE ACTIVE ALPHA VERSUS ACTIVE SHARE ALONE ANNUALIZED RELATIVE PERFORMANCE FOR YEAR 2000 TO 2012 5% 4% 3% 2% 1% 0% Within the large cap growth space, the top decile measured by year-end 2000 active share outperformed the benchmark by an impressive 3.73% annualized over the period measured. However, the top decile measured by the year-end Adverse Active Alpha score outperformed by 4.60% annualized. Within large cap value, the top decile as measured by active share outperformed by 1.83% while the top decile Adverse Active Alpha managers outperformed by 3.26%. This analysis reveals that using the Adverse Active Alpha scores resulted in a meaningful pickup in performance within both style categories. THE MECHANICS OF ADVERSE ACTIVE ALPHA ADVERSE Value Adverse Active Alpha Active Share Alone The adverse component of the model awards higher scores to managers that performed well in markets adverse toward active managers (i.e. periods when the majority of managers underperformed). We do this by breaking down managers performance track records into snapshots of time and scoring each time period based on a number of factors that help determine how difficult it has been for active managers to outperform. Scoring track records based on the most significant factors, we attempt to neutralize their effects on active manager performance and find managers that have performed well while others struggled. We also consider the percentage of money managers that have outperformed their respective indexes in any given period as a measure of the degree of difficulty. ACTIVE The active component of the ranking model views more favorably managers with high active share. Active share measures how different a manager s portfolio is from its index. The active share calculation sums the absolute values of each portfolio holding weight minus the benchmark weight and divides by two. For purposes of the ranking model, active share is calculated relative to each manager s style benchmark. Much work has been done on this subject within the financial community. But suffice to say that most studies, as well as our own work, indicate that as a group, active managers with higher active share outperform the market over time. This is not to say that every manager with high active share will outperform, but that as a group it is a good universe from which to choose. As such, one component of Adverse Active Alpha looks for managers with high active share. Along with high active share, we also look for managers with moderate to low tracking error. Tracking error measures how closely a portfolio s return follows its index return and is calculated by taking the standard deviation of the manager excess return relative to its style benchmark. By limiting tracking error, we attempt to find managers that are not seeking to outperform based on factor bets such as large sector or industry bets. While such bets may at times be profitable, they tend to be more unpredictable and can often turn quickly. Additionally, processes that emphasize factor bets are often less repeatable. As noted by Antti Petajisto, one of the pioneers of active share, factor bets generate large volatility with respect to the index even with relatively small active positions Funds that focus on factor bets have also lost money for their investors. He also notes that Most of the outperformance came from the stock pickers and that active stock picking funds (higher active share funds) tended to exhibit skill, but funds taking factor bets did not. 3 As noted above, factor bets can at times be quite profitable. The question is how likely they are to be repeatable in the future and predictable in advance. When looking back at past performance (either abnormally strong or weak), it is quite likely that one might find a manager or two with large factor exposure such as a large bet on the technology sector in the top performer ranks (or bottom). However, the question is what is the likelihood of those managers performing well in the future? Often, these managers are unable to repeat their strong performance. WHAT KIND OF MANAGERS SCORE WELL? A question that often comes up is what kind of managers typically score well according to the Adverse Active Alpha rankings? The most common characteristic is that the managers emphasize fundamental, bottom-up stock picking, as opposed to more quantitative based options. Otherwise, the managers can vary by sub-style within their respective categories. Although some of the managers are fairly concentrated, they are not typically highly concentrated. 3
Looking at the average characteristics for the top-decile managers as of year-end 2012, we can get an idea of what kind of managers rank well. Overall, the large cap growth managers are fairly concentrated although not overly so and they on average have slight market capitalization discount to the index, although this is not uncommon for the large cap growth universe as a whole. In terms of valuation, price/earnings and price/book ratios are at a discount to the index, while the price/sales ratio is in line with the index. Table 5 ADVERSE ACTIVE ALPHA LARGE CAP GROWTH MANAGER PORTFOLIO CHARACTERISTICS Top Decile Adverse Active Alpha Managers Russell 1000 Number of Holdings 42 611 Average Market Cap 29,990 42,784 P/E Ratio 17.11 18.38 Price/Book 3.30 4.35 Price/Sales 1.94 1.87 CONCLUSION The Adverse Active Alpha ranking model shows impressive results in pointing toward active money managers with the ability to deliver outperformance on a going forward basis. Back tested performance in the large cap space showed positive results relative to benchmarks and peers. However, we would emphasize that we consider the rankings a good start to an overall comprehensive due diligence process. While highly ranked managers performed well as a group in our back tests, not all of the managers will outperform. Additionally, highly ranked managers can have differing risk profiles that might not be suitable for all investors. Factors such as manager turnover and changes to investment process can partially or fully negate a positive Adverse Active Alpha ranking. With that said, it would be difficult to make the case that the model does not point toward generally desired active manager characteristics such as strong performance in a variety of market environments and high active share. And so in the ever elusive quest for alpha, Adverse Active Alpha appears a good place to start. As can be seen in Table 6, top ranked large cap value managers generally were not overly concentrated, but did as a group have a market capitalization discount relative to the Russell 1000 Value Index. Valuation characteristics were generally in line with those of the index. Table 6 ADVERSE ACTIVE ALPHA LARGE CAP VALUE MANAGER PORTFOLIO CHARACTERISTICS Top Decile Adverse Russell Active Alpha 1000 Value Value Managers Number of Holdings 64 648 Average Market Cap 33,996 46,154 P/E Ratio 13.52 13.31 Price/Book 1.92 1.62 Price/Sales 1.19 1.21 1 Performance for style categories based on Morningstar style categories adjusted by CG IAR for style consistency where appropriate. 2 Cremers, Martijn, and Petajisto, How Active is Your Fund Manager? A New Measure That Predicts Performance, AFA 2007 Chicago Meetings Paper; EFA 2007 Ljubljana Meetings Paper; Yale ICF Working Paper No. 06-14, available at SSRN: http://ssrn.com/abstract=891719 3 Petajisto, Antti, Active Share and Mutual Fund Performance, Financial Analysts Journal, Volume 69, Number 4, July/August 2013. 4
GLOSSARY OF TERMS Active Share is a measure of the percentage of stock holdings in a manager s portfolio that differ from the benchmark index; Active Share is calculated by taking the sum of the absolute value of the differences of the weight of each holding in the manager s portfolio versus the weight of each holding in the benchmark index and dividing by two. Alpha measures the difference between a portfolio s actual returns and its expected performance, given its level of risk as measured by Beta. A positive Alpha figure indicates the portfolio has performed better than its Beta would predict. A negative Alpha indicates the portfolio s underperformance given the expectations established by the Beta. The accuracy of the Alpha is therefore dependent on the accuracy of the Beta. Alpha is often viewed as a measurement of the value added or subtracted by a portfolio s manager. Average Capitalization the total capitalization of the portfolio divided by the number of securities in a portfolio. Dividend Yield annual dividend per share divided by price per share. Dividend Yield for the portfolio is a weighted average of the results for the individual stocks in the portfolio. EPS Forecast a measure of one year earnings (cash flow or dividends) per share growth from the prior fiscal year (FY0) to the current fiscal year (FY1) using analyst consensus forecasts. is expressed as a percent. The FY1 EPS (earnings per share) growth rate for the portfolio is a weighted average of the forecasts for the individual stocks in the portfolio. EPS 5 Year Historical The weighted average annualized earnings per share growth for a portfolio over the past five years. Excess Return represents the average quarterly total return of the portfolio relative to its benchmark. A portfolio with a positive Excess Return has on average outperformed its benchmark on a quarterly basis. This statistic is obtained by subtracting the benchmark return from the portfolio s return. Historical EPS - calculated by regressing over time the quarterly earnings per share for the past 20 quarters to determine the share's historical growth rate in earnings. The quarterly historical growth rate for each share is then annualized and the Historical EPS shown in this report is the weighted average of these results. Market Cap ($M) the average portfolio market capitalization (market price multiplied by shares outstanding), weighted by the proportion of the portfolio s assets invested in each stock. Median Cap by Portfolio Weight the midpoint of market capitalization (market price multiplied by shares outstanding) of a portfolio s stock holdings, weighted by the proportion of the portfolio s assets invested in each stock. Stocks representing half of the portfolio s holdings are above the median, while the rest are below it. P/E - Forecast 12-Mo. The price/earnings ratio for the stock based on the most recent closing price divided by the annual mean expected earnings for the current fiscal year (FY1 EPS forecast). P/E for the portfolio is a weighted average of the results for the individual stocks in the portfolio. P/E Trailing 12-Mo. the current price of a stock divided by the most recent 12 months trailing earnings per share. P/E for the portfolio is a weighted average of the results for the individual stocks in the portfolio. Price-to-Book price per share divided by book value per share. Price-to-Book for the portfolio is a weighted average of the results for the individual stocks in the portfolio. Price-to-Sales Price to sales is calculated by dividing a stock's current price by its revenue per share for the trailing 12 months. Standard Deviation quantifies the volatility associated with a portfolio s returns. The statistic measures the variation in returns around the mean return. Unlike Beta, which measures volatility relative to the aggregate market, Standard Deviation measures the absolute volatility of a portfolio s return. Tracking Error represents the Standard Deviation of the Excess Return. This provides a historical measure of the variability of the portfolio s returns relative to its benchmark. A portfolio with a low Tracking Error would have quarterly Excess Returns that have exhibited very low volatility. IMPORTANT DISCLOSURES The foregoing information, analysis, opinions, and conclusions are those of Morgan Stanley Wealth Management. They represent the views of Morgan Stanley Wealth Management as of the date set forth above and are based upon such information obtained from various sources as Morgan Stanley Wealth Management has deemed relevant. There is no guarantee that all relevant information has been obtained, reviewed, or considered. Morgan Stanley Wealth Management has not considered the actual or desired investment objectives, goals, strategies, guidelines, or factual circumstances of any investor in the fund or portfolio. Consequently, the opinions and conclusions of Morgan Stanley Wealth Management set forth above have not been reached with reference to the circumstances of any such investor. Each such investor, therefore, should weigh the opinions and conclusions of Morgan Stanley Wealth Management therein against its own investment objectives and goals. Report for Use Only in Investment Advisory Programs This report is only to be used in Morgan Stanley Wealth Management investment advisory programs and not in connection with brokerage accounts. CG IAR Services Only Apply to Certain Investment Advisory Programs CG IAR evaluates certain investment products for the purposes of some but not all of Morgan Stanley Wealth Management s investment advisory programs (as described in more detail in the applicable Form ADV Disclosure Document for Morgan Stanley Wealth Management). If you do not invest through one of these investment advisory programs, Morgan Stanley Wealth Management is not obligated to provide you notice of any CG IAR status changes even though it may give notice to clients in other programs. Strategy May Be Available as a Separately Managed Account or Mutual Fund Strategies are sometimes available in Morgan Stanley Wealth Management investment advisory programs both in the form of a separately managed account ( SMA ) and a mutual fund. These may have different expenses and investment minimums. Your Financial Advisor or Private Wealth 5
Advisor can provide more information on whether any particular strategy is available in more than one form in a particular investment advisory program. Consider Your Own Investment Needs This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities (includes securities of Morgan Stanley, and/or their affiliates if shown in this report). Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Performance and Other Portfolio Information General Past performance does not guarantee future results. There is no guarantee that this investment strategy will work under all market conditions. As a result of recent market activity, current performance may vary from the performance referenced in this report. Benchmark index Depending on the composition of your account and your investment objectives, any indices shown in this report may not be an appropriate measure for comparison purposes and are therefore presented for illustration only. Indices are unmanaged. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, accrued income and capital gains. Past performance of indices does not guarantee future results. You cannot invest directly in an index. Performance of indices may be more or less volatile than any investment product. The risk of loss in value of a specific investment (such as with an investment manager or in a fund) is not the same as the risk of loss in a broad market index. Therefore, the historical returns of an index will not be the same as the historical returns of a particular investment product. Other data Portfolio analysis may be based on information on less than all of the securities held in the portfolio. For equity portfolios, the analysis typically reflects securities representing at least 95% of portfolio assets. This may differ for other strategies, including those in the fixed income and specialty asset classes, due to availability of portfolio information. Other data in this report is accurate as of the date this report was prepared unless stated otherwise. Data in this report may be calculated by the investment manager, Morgan Stanley Wealth Management or a third party service provider, and may be based on a representative account or a composite of accounts. Securities holdings Holdings are subject to change daily, so any securities discussed in this report may or may not be included in your portfolio if you invest in this investment product. Your portfolio may also include other securities in addition to or instead of any securities discussed in this report. Do not assume that any holdings mentioned were, or will be, profitable. Sources of Data Material in this report has been obtained from sources that we believe to be reliable, but we do not guarantee its accuracy, completeness or timeliness. Third party data providers make no warranties or representations relating to the accuracy, completeness or timeliness of the data they provide and are not liable for any damages relating to this data. Asset Class and Other Risks Investing in stocks, mutual funds and exchange-traded funds ( ETFs ) entails the risks of market volatility. The value of all types of investments may increase or decrease over varying time periods. Nondiversification: For a portfolio that holds a concentrated or limited number of securities, a decline in the value of these investments would cause the portfolio s overall value to decline to a greater degree than a less concentrated portfolio. Portfolios that invest a large percentage of assets in only one industry sector (or in only a few sectors) are more vulnerable to price fluctuation than those that diversify among a broad range of sectors. Value and growth investing also carry risks. Value investing involves the risk that the market may not recognize that securities are undervalued and they may not appreciate as anticipated. investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations. International securities may carry additional risks, including foreign economic, political, monetary and/or legal factors, changing currency exchange rates, foreign taxes and differences in financial and accounting standards. International investing may not be for everyone. These risks may be magnified in emerging markets. Small- and mid- capitalization companies may lack the financial resources, product diversification and competitive strengths of larger companies. The securities of small capitalization companies may not trade as readily as, and be subject to higher volatility than, those of larger, more established companies. 6
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